Has the Market Bottomed? Beware the Head Fakes on the Way Down.
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About the author: Jeffrey Schulze, CFA, is a director and investment strategist at ClearBridge Investments, a subsidiary of Franklin Templeton.
The U.S. economy is at an inflection point. With a recession appearing more and more likely, many investors are wondering when a durable equity market bottom may be formed. Pessimism concerning future corporate earnings has been discounted into equity pricing, yet as with past recessionary downturns, the bottoming process will take some time—if it does set in.
Markets usually bottom two-thirds of the way through a recession. Since labor market data suggests a recession has not begun, markets likely will remain volatile as unknown risks unfold.
After an ultimately rough September washed out a lot of investor sentiment, another leg up for stocks would not be surprising. We continue to favor portfolio tilts toward quality and defensive equities until clearer paths emerge for economic activity and earnings.
Investors almost certainly will have to sort out market head fakes, in the form of false starts followed by sell-offs. Known as “counter-trend rallies,” in bear markets these pockets of strength usually give way to a lower low. We just lived through one: The July rally pointed to a soft landing, but the U.S. Federal Reserve’s pronouncements from Jackson Hole dashed those hopes in August.
While this summer’s counter-trend rally of +17% was encouraging, two of the past three recessions endured even larger counter-trend rallies before final market depths were reached.
The path forward for equities will be determined by the trajectory of the economy and its effect on future earnings. A bear market has two phases: multiple compression, and declining earnings expectations. Lower price/earnings ratios have largely driven market performance year to date.
Still, the negative earnings revisions cycle has barely begun. Expectations for the next 12 months are down only 1.4% from their peaks. Earnings expectations in the past three recessions moved down 26% on average, although earnings-expectation lows typically followed market bottoms.
In most recessions, earnings typically drop 15-20%, far more than what companies are currently reporting.
Yet corporate management teams have begun to cut guidance. This has led sell-side analysts to make similar downward revisions, but the trend is modest. Some is simply a function of timing, this being the season when management teams typically update and release guidance.
The U.S. had been in recession for nine months at the time of the Lehman Brothers bankruptcy during the global financial crisis of 2007-2009. By that point, sell-side analysts taking their cues from corporate management teams and their guidance had cut estimates by only 4% on a next 12-month basis.
But today’s investors should take little solace in earnings holding up well so far. They are likely to become headwinds.
In late September, the American Association of Individual Investors Sentiment Survey reported the fourth-worst bull-bear spread in its 35-year history: -43.2. It remained among the 10 lowest readings in its history last week.
Such pessimistic investor sentiment historically has been a sign of retail capitulation, signaling near-term buying opportunities. Returns following the survey’s previous worst 10 readings averaged 2.7% and 6% over the subsequent one month and three months, respectively.
Most market drawdowns since the global financial crisis have been followed by V-shaped recoveries. This was in part a function of the slow-growth, low-inflation regime. When financial conditions tightened, the Fed needed to step in rapidly in order to head off a recession, boosting financial markets.
Today’s economic backdrop is different, and easing financial conditions are counterproductive to the announced aims of policymakers. The Fed call is replacing the Fed put. With a different response function, the recovery also is likely to look different.
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